1 Submitted By:- Sugandh Kumar Choudhary. R1813-B41 10805900 Term Paper Of FIS
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Submitted By:-
Sugandh Kumar Choudhary.
R1813-B41
10805900
Term Paper
Of
FIS
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I ntroduction:-
In its report submitted to the Government of India in December 1991, the
NarasimhanCommittee on Financial System suggested several reform measures
for India¶s financialsystem. The Committee recommended gradual
liberalization of the banking sector byadopting measures such as reduction of
statutory preemptions, deregulation of interestrates and allowing foreign and
domestic private banks to enter the system. Along withthese, the Committee
also recommended adoption of prudential regulation relating tocapital
adequacy, income recognition, asset classification and provisioning
standards.While the liberalization was aimed at bringing about competition and
efficiency intoIndia¶s banking system, the prudential regulation was aimed at
strengthening thesupervisory system, which is important in the process of
liberalization.
The Narasimhan Committee endorsed the internat ionally accepted norms for
capitaladequacy standards, developed by the Basel Committee on Banking
Supervision(BCBS).BCBS initiated Basel I norms in 1988, considered to be the
first move towardsrisk-weighted capital adequacy norms. In 1996 BCBS amended the Basel I norms and in1999 it initiated a complete revision of the
Basel I framework, to be known as Basel II.In pursuance of the Narasimhan
Committee recommendations, India adopted Basel Inorms for commercial
banks in 1992, the market risk amendment of Basel I in 1996 andhas committed
to implement the revised norms, the Basel II, from March 2008.
Basel II regime in I ndia. The paper tries to identify limitations, gaps and
inadequacies inthe Indian banking system which may hamper the realization of
the potential benefits ofthe new regime. In other words, the paper attempts toexamine whether the costsimposed by implementing the new regime will be
adequately compensated by animprovement in the system.
While the literature on Basel framework is burgeoning, studies particularly
dealing withIndia are limited.This paper attempts to fill the gap. First we
Capital Adequacy Norms
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discuss in brief Basel I,market risk amendment of Basel I and Basel II. Then we
present the current state ofaffairs with respect to capital adequacy ratio in
India. Finally we discuss a few issues andemerging challenges for the Indian
banking system in the wake of Basel II.
P rogress of international capital adequacy norms
The international financial community has witnessed several significant
developments inthe area of risk management and banking supervision over the
last two decades. In 1988,BCBS introduced risk-based capital adequacy norms
through Basel I accord (BCBS1988). Basel I mainly incorporated credit risk in
calculating the capital adequacy normsof banks. It recommended a bank¶s
regulatory capital at 8 per cent of its risk-weightedasset, where assets were
risk-weighted according to their credit risk. In 1996, anamendment was made
to Basel I to incorporate market risk in addition to credit risk in the weighing scheme (BCBS 1996). In July 1999, BCBS initiated the process of replacingthe
current framework with a revised version, the Basel II. After several rounds
ofdiscussions, consultations and deliberations within the global financial and
bankinginstitutions, Basel II has evolved as a revised and comprehensive
framework forprudential regulations to replace the current Basel I
framework.In 2007, more than 100 countries are following Basel I norms.
As far as Basel II isconcerned, a survey by Financial S tability Institute (FSI) of
the Bank for InternationalSettlement in 2006 revealed that 95 countriesintended to adopt Basel II, in some form orthe other, by 2015. Out of these
countries, the 13 BCBS member countries have initiatedBasel II implementation
process in 2007.
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An overview of Basel II .
Basel II:
Basel II is a much more comprehensive framework of banking supervision.
Itnot only deals with CRAR calculation, but has also got provisions for pervisory reviewand market discipline.
Thus, Basel II stands on three pillars:
M inimum regulatory capital ( P illar 1):
This is a revised and extensiveframework for capital adequacy standards, where
CRAR is calculated byincorporating credit, market and operational risks.
Supervisory review ( P illar 2):
This provides key principles for supervisoryreview, risk management guidance
and supervisory transparency andaccountability.
M arket discipline ( P illar 3):
This pillar encourages market discipline bydeveloping a set of disclosure
requirements that will allow market participants toassess key pieces of
information on risk exposure, risk assessment process and capital adequacy of a
bank.
M inimum Regulatory Capital under Basel II
Under Basel II, CRAR is calculated by taking into account three types of risks:
creditrisk, market risk and operational risk. The approaches for each one of
these risks isdescribed below.
Credit risk:
There are two approaches for credit risk, viz., the Standardized Approach(SA)
and the Internal Ratings Based (IRB) approach. In SA, credit risk is measured
inthe same manner as in Basel I, but in a more risk sensitive manner, i.e. by
linking creditratings of credit rating agencies to risk of the assets of the bank.
This, according toBCBS, is an improvement over Basel I, where categorization
of the assets into five risk-weight categories was an ad hoc categorization.
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BCBS has provided an example of howrisk weights can be linked with the credit
ratings. The responsibility of providing therisk-weights corresponding to
various assets, under SA, lies with the supervisoryauthority of a country. As far
as the IRB approach is concerned, banks will be allowed touse their internal
estimates of credit risk, subject to supervisory approval, to determinethe capital charge for a given exposure. This would involve estimation of
severalparameters such as the probability of default (PD), loss given default
(LGD), exposure atdefault (EAD) and effective maturity (M) corresponding to a
particular debt portfolio.
M arket risk:
As far as market risk is concerned, Basel II retains the recommendations of
the 1996 Amendment.
Operational risk :
Basel II has introduced a new kind of risk, called the µoperational risk¶
in calculating CRAR. It is defined as³the risk of direct or indirect loss resulting
frominadequate or failed internal processes, people and systems or from
external events.´Inorder to calculate the capital charges for operational risk,
three approaches ± BasicIndicator Approach (BIA), Standardized Approach
(SA) and Advanced MeasurementApproaches (AMA) ± have been suggested. In
the BIA, an estimate of the capital chargefor operational risk is provided by
averaging over a fixed percentage of positive annualgross income of the bank
over the previous three years.In this estimate, negativeincome s are excluded.
Under SA, at first the bank¶s business activities are divided intoeight business
lines. For each business line, a capital charge is calculated bymultiplyingthe
gross income of the business line by a factor.A capital charge for each busine ss
lineis thus calculated for three consecutive years. The overall capital charge is
calculated asthe three-year average of the simple summation of the charges
across business lines ineach year. Under AMA, a bank can, subject to
supervisory approval, use its ownmechanism for determining capital
requirement for operational risk.
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Capital adequacy standard in I ndia
In India, at present, there is a µthree track¶ approach for Basel compliance ±
thecommercial banks are Basel I compliant with respect to credit and market
risks; the urbanThis has been currently fixed at 15 per cent.This factor is called
the ß factor, and pre-fixed by BCBS for each business line. For more, refer to BCBS(2006).cooperative banks maintain capital for credit risk as per Basel I
and market risk throughsurrogate charges; and the rural banks have capital
adequacy norms that are not on parwith the Basel norms (Leeladhar 2006,
Reddy 2006). The three track approach isjustified by the necessity to maintain
varying degree of stringency across different typesof banks in India reflecting
different levels of operational complexity and risk appetite.The three track
approach is also justified in order to ensure greater financial inclusion andfor
an efficient credit delivery mechanism (Reddy 2006) .
India adopted Basel I norms for scheduled commercial banks in April 1992, and
itsimplementation was spread over the next three years. It was stipulated that
foreign banksoperating in India should achieve a CRAR of 8 per cent by March
1993 while Indianbanks with branches abroad should achieve the 8 per cent
norm by March 1995. Allother banks were to achieve a capital adequacy norm
of 4 per cent by March 1993 and the8 per cent norm by March 1996.
In its mid-term review of Monetary and Credit Policy in October 1998, the
Reserve Bankof India (RBI) raised the minimum regulatory CRAR requirement to 9 per cent, andbanks were advised to achieve this 9 per cent CRAR level by
March 31, 2000.Thus, thecapital adequacy norm for India¶s commercial banks
is higher than the internationallyaccepted level of 8 per cent.The RBI responded
to the market risk amendment of Basel I in 1996 by initiallyprescribing various
surrogate capital charges such as investment fluctuation reserve of 5per cent of
the bank¶s portfolio and a 2 .5 per cent risk weight on the entire portfolio
forthese risks between 2000 and 2002. These were later replaced with VaR -
based capitalcharges, as required by the market risk amendments, which
became effective from March2005. India has gone a step ahead o f Basel I inthat the banks in India are required tomaintain capital charges for market risk
on their µavailable for sale¶ portfolios as well ason their µheld for trading
portfolios¶ from March 2006 while Basel I requires market riskcharges for
trading portfolios only.
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The RBI has announced the implementation of Basel II norms in India for
internationallyactive banks from March 2008 and for the domestic commercial
banks from March 2009.Before we go into details of several issues facing the
banking industry in India in thewake of Basel II, we briefly describe the current
state of affairs with respect to capitaladequacy of India¶s banking industry.Inthe first stage of the application of capital adequacy norms and prudential
accounting standards, the
T he present state of capital standards for commercial banks in I ndia
The scheduled commercial banks in India are categorized into the following
groups:nationalised banks, other public sector banks, State Bank of India (SBI)
group, Indianprivate banks (further categorized as old private banks and new
private banks) andforeign banks. Sometimes the first two categories are
clubbed together as there is onlyone bank in the category µother public sector bank¶, the Industrial Development Bank ofIndia (IDBI) bank. The fir st three
categories are commonly known as public sectorbanks. At the end of March
2006, there were altogether 84 banks operating in India,consisting of 20
nationalised banks (including IDBI bank), 8 banks in SBI group, 19 oldprivate
banks, 8 new private banks and 29 foreign banks. The ratio of total assets of
thecommercial banks to the GDP of India stood at 86.9 per cent at end -March
2006. At theend of March 2006, the share of public sector banks in the total
banking assets of thecountry stood at 72.3 per cent.Old and new private banks
together constituted about 20per cent, while foreign banks accounted for 7.2
per cent of the total banking assets ofIndia in March 2006.
Table 1 provides yearly frequency distribution of different bank groups by their
CRARlevels for the period 1996-2006. As shown in the table, by the end of
March 1997, all but2 nationalised banks and 4 private banks were short of
meeting the capital adequacynorm. The SBI group and the foreign banks had
achieved the minimum regulatory normby March 1997. Although a few banks
were having negative CRAR during 2000-02, allbanks achieved the minimum
regulatory level by 2006. As shown in Table 1, majority ofthe banks in all bank categories have achieved a CRAR level of more than 10 per cent byMa rch 2006,
indicating good financial health of the banking industry, in terms of
capitaladequacy norms, over the recent years.
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The average level of CRAR for the Indian banking groups for the period 1999 -
2006 ispresented in Table 2. As shown by this table, the average CRAR level
for the bankingindustry has stood consistently between 11 and 12 per cent
during 1999-2006, which ismuch higher than the current minimum regulatory
requirement of 9 per cent and theinternational minimum requirement of 8 per cent.As seen from Table 2, overall CRAR for the banking system has marginally
declinedsince 2005. Between 2004 and 2005, the overall CRAR declined by 0.1
percentagepoints and between 2005 and 2006, this decline was by 0.5
percentage points. Bankgroup wise, between 2004 and 2005, µold private
banks¶ recorded the highest decline of1.2 percentage points in CRAR followed
by a 1 percentage point fall for SBI group andthe foreign bank group each. The
µnew Private Banks¶ recorded a rise of 1.9 percentagepoints in CRAR a nd the
nationalised banks recorded a rise of 0.1 percentage points. Thenet result was
a marginal decline in CRAR for the banking system as a whole. RBIattributed this decline to theincrease in total risk -weighted assets relative to the capital,for
the first time since March 2000(RBI 2005b).
The increase in risk-weighted assetswas due to a higher growth in the loan
portfolio of banks and higher risk weights madeThis share was at 75.3 per cent
at end-March 2005.applicable for housing loans, the most rapidly increasing
component of retail loans forbanks.
Following a similar pattern, CRAR levels for all but one banking group
recorded adecline between 2005 and 2006. The highest decline of 1 percentage point was observedfor µforeign banks¶, followed by a decline by 0.8 percentage
points for µnationalised¶ andµold private banks¶, of 0.7 percentage points for
µother public sector bank¶ (IDBI beingthe sole member of this group) and a
decline by 0.5 percentage points for the SBI group.During this period µnew
private banks¶ showed a rise of 0.5 percentage point in CRAR.The resultant
change in CRAR for the banking system as a whole was a decline of
0.5percentage points. This overall decline in CRAR could be attributed to three
factors ± (i)higher growth in loan portfolio of banks as compared to investment
in governmentsecurities, (ii) increase in risk weights for personal loans, real
estate and capital marketexposure, and (iii) application of VaR -based capital
charge for market risk for investmentheld under µheld for trade¶ and µavailable
for sale¶ portfolios (RBI 2006).
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Notwithstanding the overall decline in CRAR recorded successively for the last
twoyears, the CRAR level remains at a satisfactory level of 12.3 per cent at the
end of March2006. As far as the individual banking groups are concerned,
IDBI bank (the solemember of the group µother public sector banks¶) had the
highest CRAR at 14.8 per centat the end of March 2006, followed by the foreignbanks with a CRAR level of 13 percent, the new domestic private banks with
12.6 per cent and the nationalised banks at12.4 per cent at the same period. At
the end of March 2006, the SBI group has anaverage CRAR of 11.9 per cent
and the old domestic private banks have an averageCRAR of 11.7 per cent.
I nternational comparison
Table 3 provides a comparative picture of the capital adequacy ratios of
differentcountries vis-à-vis India¶s. As shown by this table, CRAR of Indian
banking systemcompares well with many emerging countries such as Korea, Malaysia and South Africa.Countries such as Brazil, Indonesia, Hong Kong,
Singapore and Thailand have higherCRAR level than India in 2005 while
Japan, Taiwan, the United States and theneighbouring countries of Bangladesh
and Sri Lanka have lower CRAR levels than India.In 2005, Chi na¶s banking
system had a CRAR level of less than 8 per cent. According tothe official
website of the Chinese Government, 74 per cent of China¶s total bankingasset
could meet the 8 per cent level in 2006, compared with 0.56 per cent in 2003
whenonly eight banks complied.Thus, when compared with China, India is at a
much betterposition with respect to capital adequacy.The core capital for thebanks during this period increased from 8.1 per cent in 2004 to 8.5 per cent
in2005 since some banks raised capital from the capital market at substantial
premium (RBI 2005b).
Although the overall CRAR declined, the core capital during the period 2005 -06
increased from 8.4 percent to 9.3 per cent due to increased access by banks to
primary capital market and also due to transfer ofIFR from tier II to tier I
capital (RBI 2006).
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I mplementation of Basel II : the I ndian status
The RBI announced in May 2004 that banks in India should examine the
optionsavailable under Basel II for revised capital adequacy framework. In
February 2005, RBIissued the first draft guidelines on Basel II implementations
in which an initial target datefor Basel II compliance was set for March 2007
for all commercial banks, excludingLocal Area Banks (LABs) and Regional
Rural Banks (RRBs). This deadline was,however, postponed to March 2008 for
internationally active banks and March 2009 fordomestic commercial banks in
RBI¶s mid-year policy announcement of October 30,2006. Although RBI and
the commercial banks have been preparing f or the revisedcapital adequacy
framework since RBI¶s first intimidation on Basel II compliance, thecomplexity
and intense data requirement of Basel II have brought about severalchallenges
in its implementation. Given the limited preparation of the banking system
forBasel II implementation, this postponement is not surprising.
The final RBI guidelines on Basel II implementation were released on April 27,
2007.According to these guidelines, banks in India will initially adopt SA for
credit risk andBIA for operational risk. RBI has provided the specifics of these
approaches in itsguidelines. After adequate skills are developed, both by banks
and RBI, some banks maybe allowed to migrate towards more sophisticated
approaches like IRB. Under therevised regime of Basel II, Indian banks will be
required to maintain a minimum CRARNote that the final guidelines from RBI
were issued in April 2007, beyond the initial target date of March152007,
giving some indication of the amount of extra preparation that was requir ed
even for the RBI.of 9 per cent on an ongoing basis. Further, banks are
encouraged to achieve a tier ICRAR of at least 6 per cent by March 2010. In
order to ensure a smooth transition toBasel II, RBI has advised the banks to
have a parallel run of the revised norms along withthe currently applicable
norms.Tables A2 and A3 in Appendix present the RBI¶s scheme of risk-weights
for differentcategories of assets to be considered for credit risk under SA of
Basel II. For claims inIndian rupees, RBI¶s guidelines provide risk-weights for
direct and guarantee exposuresof the Central and State governments, exposures
to apex bodies such as RBI, DepositInsurance and Credit Guarantee
Corporation (DICGC), Credit Guarantee Fund Trust forSmall Industries
(CGTSI) and Export Credit Guarantee Corporation (ECGC), exposuresto
scheduled commercial banks and other banks, and exposures to corporate with
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variouscredit ratings. Apart from these, RBI guidelines also deal with claims in
retail portfolios,claims secured by residential property and claims secured by
commercial real estate. RBIhas also set extensive guidelines on to how to deal
with Non-Performing Assets (NPAs)in calculating risk-weighted assets. As far
as claims on foreign currency are concerned,RBI has retained th e indicative guidelines of Basel Committee, and provided risk weightsin accordance with the
credit ratings of external credit rating agencies (Table A3).
Basel II : Some issues, some challenges
Scholars have drawn attention to certain shortcomings of the original Basel II
guidelines,on the basis of which individual countries are expected to build their
regulatoryguidelines. In particular, many scholars have pointed out that
linking credit rating toregulatory capital standards may have severe macro -
economic implications. As thesovereign ratings of developing and emerging countries are not as high as theindustrialized and the high income countries,
this will have an unfavourable effect on thecredit flows to developing and
emerging economies. Empirical studies have pointed outthat Basel II may
significantly overestimate the risk of international lending todeveloping
economies.Further, credit ratings are found to be pro-cyclical (Ferri et
al.161999, Monfort and Mulder 2000). Credit rating agencies upgrade
sovereigns in times ofsound market conditions and downgrade in turbulent
times. This can potentially add tothe dynamics of emerging market crisis. Bank
and corporate ratings in emergingcountries are linked to their sovereignratings. In times of crisis, when the need for creditmay be imperative, credit
flow may diminish due to downgrading of the sovereign (andtherefore the bank
and corporate) ratings by external rating agencies, leading to bankingcrisis, in
addition to the currency/balance of payments cris is, what Kaminsky
andReinhart (1999) call µtwin crises¶. This may have severe impact on the
macro-economicstability. For example, Ferri et al. (2000) show that during the
East Asian currency crisisof 1997-98, following Moody¶s downgradation of
sovereign ratings for Indonesia, Koreaand Thailand, the corporate ratings were
also downgraded sharply in these countries,leading to a sharp fall in the
international capital flows in the region. Interestingly, evenwhen the sovereign
ratings of Korea and Thailand were upgraded in 1999 following themacro-
economic recovery, corporate ratings continued to remain µspeculative
grade¶.See, for example, Griffith-Jones et al. (2004).Further, the study also
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found that in the short term, the ratings of non-high incomecountries¶ banks are
more sensitive to changes in their sovereign ratings in a noticeablyasymmetric
manner, i.e. it is more sensitive for sovereign downgrading than
sovereignupgrading. Thus, incorporation of external credit ratings into
regulatory capitalrequirement may lead to serious macro-economicinstability.While these concerns remain for the Indian economy in general,
several issues specific toIndia¶s banking system also arise in the wake of the
new regime. In this section, wediscuss the issues specific to the banking system
of India.
RB I risk-weighing scheme
A look at the RBI¶s scheme of risk-weighing reveals certain shortcomings.
First, RBI¶sscheme provides much less risk weights to exposures to scheduled
commercial banksthan exposures to other banks/financial institutions. To bemore precise, exposure toscheduled commercial banks with current regulatory
level of CRAR will attract a risk-weight of 20 per cent while exposure to non-
scheduled banks/financial institutions withsame level of CRAR will attract 100
per cent risk-weight. This is discriminatory not onlyagainst non-scheduled
banks of sound financial health, but also against cooperative banksand micro -
finance institutions that cater to a large number of urban and rural poor
inIndia. Second, RBI¶s scheme encourages borrowers to remain unrated rather
than ratedbelow a certain level (see Tables A2 and A3 in Appendix). A rating of
B- and below willhave a higher risk-weight of 150 per cent, while an unrated entity will have a risk-weightof 100 per cent. If borrowers consequently choose
to remain unrated, then they wouldreceive a risk -weight of 100 per cent under
Basel II which is same as under Basel I, thusleading to no significant
improvement in the risk-weighted asset calculation.
I ssues on credit rating industry
As the SA approach of credit risk is dependent on linking risk weights to the
creditratings of an external rating agency, credit ratings are being
institutionalized into theregulatory framework of banking supervision. This
raises four important issues that needto be looked into. These are ± the quality
of credit rating in India, the level of penetrationof credit rating, lack of issuer
ratings in India and last but not the least, the effect of thecredit rating scheme
on Small and Medium Enterprises (SMEs) and Small Scale Industry(SSI)
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lending. In this section we elaborate each of them.The credit rating industry in
India presently consists of four agencies: Credit RatingInformation Services of
India Limited (CRISIL), Investment Information and CreditRating Agency of
India (ICRA), Credit Analysis & Research Limited (CARE) and
FitchIndia.These agencies provide credit ratings for different types of debt instruments ofCRISIL is the oldest and largest agency, with abou t 60 per cent
of the total market share in 2006. Asubsidiary of Standard & Poor¶s, CRISIL
was incorporated in 1987. ICRA, an associate of Moody'sInvestors Service,
was established in 1991 and CARE was established in 1993. Fitch Ratings
IndiaPrivate Limited, formerly known as Duff & Phelps Credit Rating India
Private Ltd. prior to 2001, is awholly-owned subsidiary of the Fitch group that
started operating in India since 1996.short and long terms of various
corporations. Very recently, they have also commencedcredit rating for SMEs.
Apart from that, ICRA and CARE also provide credit rating forissuers of debt instruments, including private companies, municipal bodies and
Stategovernments.Basel guidelines entrust the national banking supervisors
with the responsibility toidentify credit rating agencies for assessing borrowers.
RBI has recognized all four creditrating agencies as eligible for the purposes of
risk-weighting banks¶ claims for capitaladequacy. Further, the following
international rating agencies are recognized for risk -weighing claims on
foreign entities: Fitch, Moody¶s and Standard & Poor¶s (RBI 2007b).Further,
RBI has recommended the use of only µsolicited¶ ratings.Credit rating quality:
The literature on India¶s credit rating industry is scanty. However, the few studies available point to the low and unsatisfactory quality. In Gill
(2005),ICRA¶s performance in terms of credit rating and provision of timely
and completeinformation on the rated companies has been studied. Analysing
the ICRA ratings for theperiod 1995-2002, the study finds that many of the debt
issues that defaulted during theperiod were placed in ICRA¶s µinvestment
grade¶ until just before being dropped to theµdefault grade¶. These were not
gradually downgraded, rather they were suddenlydumped into µd efault grade¶
at the last moment from an µinvestment grade¶ category.Further some
defaulting issues were continuously reaffirmed as investment grade. Inprevious
studies, Raghunathan and Varma (1992; 1993) evaluated the ratings
publishedby CRISIL in India and found that CRISIL ratings not only do not
adequately reflect thefinancial ratios of the rated entity, but also are internally
inconsistent. In these studies,CRISIL ratings were found to be very liberal by
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international standards. For example,what CRISIL rated as AAA would usually
receive a rating of BBB or lower byinternational standards. Further,
companies rated in the same category by CRISILreflected a wide variety of
credit-worthiness, implying the lack of discriminatory powerof the ratings vis-à-
vis the credit-worthiness of the entities in the same rating category.Theliterature on credit rating identifies lack of µunsolicited¶ rating as an important
factorleading to poor quality of credit rating.In India all ratings are µsolicited¶,
i.e. allratings are paid for by the rated entity. This creates a conflict of interest
on the part of therating agency since it is dependent on the fees of the rated
entity for its business. Thus,credit rating industry in India is driven mostly by
the rated entities. Under the presentsystem, issuers of bond/debt instruments
may go to any number of agencies for a ratingof their bonds/debt instruments
and have the right to accept or reject the rating. Further,the rating cannot be
published unless accepted by the issuer.Thus, while RBI has recognized all four credit rating agencies as eligible for the purposeof capital adequacy norm, one
is faced with the lack of objective assessment of thequality of these agencies.
The few available studies indicate poor track record of thecredit rating quality
in India. In addition to this, RBI¶s recommendation for use of onlysolicited
ratings causes some concern, owing to the problem of moral hazard.
Low penetration of credit rating: The second important issue in India¶s credit
ratingindustry is the low penetration of credit rating in India. A study in 1999
revealed that outof 9,640 borrowers enjoying fund -based working capital facilities from banks, only 300were rated by major agencies.As far as individual
investors are concerned, the level ofconfidence on credit rating in India is very
low. In an all-India survey of investorpreference in 1997, it was found that
about 41.29 per cent of the respondents (out of atotal number of 2,819
respondents) of all income classes were not aware of any creditrating agency in
India; and of those who were aware, about 66 per cent had no or lowconfidence
in the ratings given by credit rating agencies (Gupta et al. 2001).
Thelegitimacy brought about by Basel II for credit ratings of borrowers will
definitelyincrease the penetration of the industry. However, until such time,most loans will begiven 100 per cent risk weightage (since an unrated claim
gets 100 per cent weightage);thus leading to no significant improvement of
Basel II over Basel I.
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I ssuer ratings:
Presently credit rating in India is restricted to µissues¶ (the instruments)rather
than to µissuers¶. Ratings to issuers become important as the loans by
corporatebodies and SMEs are to be weighted as per their ratings. Of late
agencies like ICRA andCARE have launched issuer ratings for corporations,municipal bodies and the Stategovernment bodies. Further, all agencies, with
direct support from the Government ofIndia, have launched SMEs rating. Until
such efforts pick up rapidly, issuers will beassigned 100 per cent weightage,
leading to no improvement in the risk-sensitivecalculation of the loans. Thus, in
this account too, the implementation of Basel II wouldnot lead to significant
improvement over Basel I.
E ffects on S ME s and SS I lending :
Besides agriculture and other social sectors, Small Scale Industry is treated as
a priority lending sector by RBI.SSI accounts for nearly 95per cent of industrial
units in India, 40 per cent of the total industrial production, 35 percent of the
total export and 7 per cent of GDP of India. In spite of its importance onIndian
economy, SSI receives only about 10 per cent of bank credit (Table A4
inAppendix). As banking reforms have progressed, credit to SSI has fallen. The
SSI sectorin India is so far out of the reach of the credit rating industry. Under
the proposed BaselII norms, banks will be discouraged to lend to SSI that is not
rated because a loan tounrated entity will attract 100 per cent risk -weight.Thus, bank lending to this sector mayfurther go down.In a recent initiative to
promote credit rating of SMEs including SSI, the Government ofIndia had
launched SMEs Rating Agency (SMERA) in September 2005. It is a
jointinitiative of Small Industries Development Bank of India (SIDBI), Dun and
BradstreetInformation Services India (D&B), Credit Information Bureau India
Limited (CIBIL) andLeeladhar (2005).Industrial classifications of India are
formally divided into Large/Medium industry and Small industry.Due to this
structure, the term µSMEs¶ is not defined formally and properly in India. With
regard to SSI,see Nikaido (2004).
The directed credit for commercial banks was introduced in 1974 and currently
banks are asked to21allocate 40 per cent of their credit to the p riority sector.16
major banks in India. Apart from SMERA, other rating agencies have also
launchedSMEs rating.
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As an incentive to get credit rating, Government of India currently provides a
subsidy of75 per cent of the rating fees to SMEs who get a rating. Net of this
subsidy, the ratingfees for SMEs with annual turnover of less than Rs. 50 lakh
are as follows: Rs. 19,896 fora rating by CRISIL, Rs. 19,896 for a rating by
ICRA, Rs. 7,400 for a rating by CARE andRs. 22,141 for a rating by Fitch India. Without the subsidy, the fees are: Rs. 40,000 forCRISIL, Rs. 40,000 for
ICRA, Rs. 29,600 for CARE and Rs. 42,000 for Fitch India.According to the
Third All India Census of SSI conducted during 2001-02 by theMinistry of
Micro, Small and Medium Enterprises, average output per unit of SSI in In diain
2001-02 was about Rs. 4 lakh.Thus, with the subsidy, SSI units will have to
spend2-5 per cent of their output as fees for credit rating. Without the subsidy,
the percentageof fees to output is in the range of 7 -11 per cent. This additional
cost of credit rating isbound to affect the economic viability of a large number
of SSI units.While introduction of credit rating for the SMEs (including SSIs)may, in the long run,improve the accounting practices of the SSI, there is also a
possibility that SMEs willcontinue to rely on the existing system of informal
credit as formal credit is likely tobecome more expensive due to the credit
rating requirement of Basel II.
Other issues
Extensive data requirement:Implementation of Basel II, particularly the
advancedapproaches like the IRB for credit risk and AMA for operational risk
would require ahuge amount of data for model building and validation. A largenumber of banks in Indialack reliable historical data due to late
computerization. Data on losses due toµoperational risk¶ are currently non-
existent. The lack of good quality historical data oncredit, market and
operational risks may make migration towards the more advancedapproaches
of risk management slow.
I mplementation cost:
Basel II will lead to increased level of capital requirements forbanks due to
incorporation of capital charges for operational risk in addition to credit
andmarket risks. According to the recent (April 2007) RBI circular, banks will
have toincrease their tier I capital by about Rs. 512,550 million within March
2009, includingraising Rs. 455,210 million from the capital market to meet the
Basel II requirements ofincreased capital. These figures were arrived at after
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conducting a simulation study of 50public and private sector banks, c onsisting
of 19 nationalised banks, SBI and its associates, 7 new private banks and 16 old
private sector banks. Among themselves, the19 nationalised banks will have to
raise Rs. 212,110 million while the 8 SBI group bankswill have to raise an
estimated Rs. 100,700 million. The 7 new private banks will have toMinistry of Small Scale Industries was renamed as the Ministry of Micro, Small and
medium Enterprisesraise Rs. 160,380 million while the equity requirement of
the 16 old private banks hasbeen estimated at Rs. 39,360 million.Further,
extensive data requirements, upgradation of technical infrastructure,
capacitybuilding and human resource development will translate into very high
implementationcost. A Bank of International Settlements (BIS) observatio n in
2004 indicated that³Asian banks are expected to spend between 7 to 10 per cent
of their global IT andbusiness operations budget on Basel II compliance for the
next four to six years.´The increased capital requirements and the hugeimplementation costs are likely to pose agreat challenge in the path of India¶s
move towards Basel II. This may in fact trigger around of consolidation in
Indian banking industry in the coming years.
Observations and Concluding Remarks
In this article, we have attempted to review the capital adequacy regime in
India. Inparticular our focus is on the present state of capital to risk-weighted
asset ratios of thebanking sector. We have observed that with respect to the
current regime of capitalstandards, the Basel I, India¶s banking industry is performing reasonably well, with anaverage CRAR of about 12 per cent, which
is not only higher than the internationallyacceptable level of 8 per cent, but also
higher than India¶s own regulatory requirement of9 per cent.The RBI has
announced that the Indian banking sector should implement the revisedcapital
adequacy norms, Basel II, by March 2008. We have discussed the limitations
inthe RBI¶s guidelines on Basel II implementation. Under the Basel II
guidelines, thecredit rating agencies will play a prominent role in determining
regulatory risk capital.The main concerns are the unsatisfactory performance of
the credit rating industry inIndia, the low credit rating penetration and the high
costs of credit rating especially forSMEs. Further, the increased requirement of
tier I capital, the high cost ofimplementation and the requirement of extensive
data and software for implementation ofBasel II will, in our view, pose a major
challenge in India¶s migration towards Basel IIregime. We have argued that if
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these issues are not tackled up front, then the end resultwould be no different
from the current Basel I norms, albeit at higher cost.Despite these challenges,
in a globalizing financial system, India will not be able to doaway with the
recent international developments such as Basel II. In the long run,adherence
to Basel II by Indian banks will result in improved accounting, riskmanagement and supervisory principles that are in line with internationally accepted
bestpractices. While the Basel II regime provides the credit rating industry with
anopportunity in terms of business expansion, it needs to be seen if the industry
is able toperform in terms of the key principles of objectivity, independence,
transparency, Business Lines, April 19, 2007 .
Basel II Framework and India: Compliance Vs. Opportunity, IBS-IBA Special
Report 2004.disclosure, resources and credibility. We argue that solicited
ratings scheme is animpediment towards this goal.Since development of IT
infrastructure is very crucial to Basel II implementation, India¶sgrowing IT
industry is likely to benefit from the increased business opportunities in thelong
run. Processes such as data analysis, model building and model validation are
likelyto be outsourced to the BPO (Business Process Outsourcing) sector,
increasing the role ofby now mature BPO industry in India. Thus, in the long
run, adherence to Basel IIregime is expected to benefit not only the banking
industry, but also several other sectorsof Indian economy, such as the cre dit
rating industry, the IT industry and the BPOindustry.
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